The strategic fit of investment bonds - Part 2: split portfolios

Strategies

David Barrett
Tuesday 31 October 2017

The reduced capacity for super contributions from 1 July 2017 will inevitably cause financial services professionals to consider alternative strategies. In this series of articles the relative merits of where and how investment bonds can fit into the list of investment strategy options of financial services professionals are examined.

Part I introduced investment bonds and their relative attractiveness if held for 10 years or more. This article, Part II, examines using investment bonds when splitting a portfolio into defensive and growth assets. And finally, in Part III, we will examine the opportunity for holding investment bonds for up to eight years.

Investment bonds become more attractive as capital gains decrease

In Part I of this article series we demonstrated that reducing the level of the capital gains return assumption of a portfolio results in an increase in the relative attractiveness of investment bonds as an investment strategy.

As capital gains tax (CGT) discounts are not available to corporate entities, capital gains realised on assets backing an investment bond are taxed in full at the corporate tax rate. This absence of CGT discounts is less of an issue if the underlying assets are predominantly income producing, such as cash and fixed interest securities (‘defensive assets’).

It follows then that positioning defensive assets in an investment bond and growth assets in personal name, where the 50 per cent CGT discount may apply, may be an effective strategy.

Splitting growth assets and defensive assets

The balanced portfolio described in the Projection Rate Assumptions below comprises 35 per cent defensive assets (cash and fixed interest) and 65 per cent growth assets (Australian and international equities and property).

Splitting the defensive and growth assets into the separate structures, that is the defensive assets into an investment bond (corporate tax rate 30 per cent) and the growth assets into personal name, will improve the overall outcome compared to holding 100 per cent of the portfolio in either an investment bond or in personal name where the individual’s marginal tax rate is 34.5 per cent or higher.

Example: Sandy invests over 10 years

Consider an investment of $100,000 over 10 years by Sandy whose taxable income exceeds $37,000 but is less than $87,000 - her marginal tax rate is 34.5 per cent, including the Medicare levy.

The outcomes over 10 years in both future values and today’s dollars for three investment options (personal name, whole of portfolio investment bond, and a split portfolio as described above) are shown in Table 1 below.

Table 1 shows that the split portfolio is (marginally) the most favourable outcome for Sandy. This outcome is consistent when varying the growth return assumptions upwards and downwards by one per cent per annum, as shown in Table 2.

Table 2: Sandy’s investment of $100,000 after 10 years ($)

Pre-tax assumed return

5.7%

6.7%

7.7%

Future value

In today’s dollars

Future value

In today’s dollars

Future value

In today’s dollars

Personal name (34.5%)

151,000

118,000

164,000

128,000

178,000

139,000

Investment bond

149,000

116,000

160,000

125,000

171,000

134,000

Split portfolio

153,000

119,000

166,000

129,000

182,000

142,000

Pre-tax assumed return

5.7%

Personal name (34.5%)

Future value: 151,000Today's dollars: 118,000

Investment bond

Future value: 149,000Today's dollars: 116,000

Split portfolio

Future value: 153,000Today's dollars: 119,000

Pre-tax assumed return

6.7%

Personal name (34.5%)

Future value: 164,000Today's dollars: 128,000

Investment bond

Future value: 160,000Today's dollars: 125,000

Split portfolio

Future value: 166,000Today's dollars: 129,000

Pre-tax assumed return

7.7%

Personal name (34.5%)

Future value: 178,000Today's dollars: 139,000

Investment bond

Future value: 171,000Today's dollars: 134,000

Split portfolio

Future value: 182,000Today's dollars: 142,000

The benefit (approximately $1,000 in today’s dollars) of the split portfolio approach appears minimal based on $100,000 invested over 10 years. Nonetheless the benefit in this case is one per cent of the invested capital.

The practicalities of managing a portfolio with defensive assets split separately from growth assets needs to be considered, with the potential costs weighed against the benefits. Reducing the defensive asset exposure when re-balancing, for example, might be problematic. Where all the defensive assets are held in the investment bond, partial cashing of the bond may be required. Alternatively, the asset allocation within the investment bond might be changed, depending on the flexibility of the investment bond product to allow changes in the asset allocation exposure.

Investor directed portfolio service (IDPS) products (commonly referred to as wrap products) may be attractive for the growth portion of the portfolio. Incorporation of investment bond options within, or complementary to, a wrap style product is an area of potential product development which is yet to emerge. If that development does emerge, it would bring together the two investment structures discussed here and potentially remove some of the practical hurdles.

Conclusion

There are pros and cons in using investment bonds over a 10-year period, or longer. The loss of any capital gains discount is a deterring factor.

However, using investment bonds for predominantly income producing assets can be an effective strategy for those subject to marginal tax rates greater than 30 per cent.

In Part III of this series, we examine whether there is a potentially better tax outcome by holding an investment bond for up to eight years.

Further reading

Read more about the strategic fit of investment bonds in our 3 part series

Projection Rate Assumptions

The assumed after-fees pre-tax projection rate of 6.7 per cent per annum used in this article is based on the asset class weightings, long term income and capital growth projection rates and other assumptions in the table below.

These rates aren’t guaranteed, are provided as an illustration only, and may vary from actual results. The projection rates aren’t intended to be and shouldn’t be relied on when making a decision about a particular financial product.

Values in today’s dollars are shown after discounting future values by the assumed consumer price index (CPI) projection rate of 2.5 per cent per annum.

More from this author

Head of Macquarie Technical Services. David has 20 years' financial services experience, with expertise in superannuation, taxation and retirement income systems and qualifications in law, mathematics and accounting.

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1 based on an after-fees assumed projection rate of 6.7 per cent per annum – see Projection Rate Assumptions

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